What are Adjustable Rate Mortgages?
Adjustable-Rate Mortgages (ARMs) are mortgage loans with interest rates that change over time. ARMs are often very attractive to buyers because they start with lower monthly payments than other kinds of mortgages, allowing younger buyers or buyers with less-than-stellar credit to buy a home. The trade-off is that your monthly payments will increase during the loan period. Adjustable Rate Mortgages can go up even when interest rates don't and won’t necessarily go down, even if interest rates do.
In short, under certain circumstances, it’s possible that you could end up owing more money than you originally borrowed, regardless of your payment record. This is called negative amortization. Thinking about buying your way out? Be careful. You may be penalized if you try to pay off your ARM early. Be sure you ask for information about any extra fees for which you would be responsible if you refinance or sell your home, and whether you would be able to convert your ARM to a fixed-rate mortgage.
You can find real-world examples of the costs and payments of an ARM, as well as mortgage calculators and loan comparisons on the Web. As you do your research, remember that your calculations do not include taxes, insurance, condo fees, HOA fees, or similar items, and that these costs can be an additional significant part of your monthly payment.
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Understanding initial rates and payments
The initial rate – and payment amount – on an ARM remains in effect for a pre-defined period of time, ranging anywhere from 1 month to 5 years or longer. For some ARMs, the initial rate and payment can vary greatly from the rates and payments later in the loan term. Even when interest rates are steady, your rates and payments can change considerably. To find out what you can expect, ask your lender to tell you the annual percentage rate (APR) of the loan. If it’s appreciably higher than the initial rate, then your rate and payments will likely be much higher when the loan adjusts, even if interest rates remain stable.
Video: How long you intend to keep your home determines ARM refinance options
What is the adjustment period?
Based on the loan agreement you sign, the interest rate and payments on ARMs change according to a schedule, called the adjustment period. These can change each month, every three months (quarterly), once a year, every 3 years, or even every 5 years. Adjustable-rate mortgages are known by the length of their adjustment periods; e.g., a “3-year ARM” has a 3-year adjustment period.
What causes the interest rates to change?
ARM interest-rate changes are determined by an indexed amount plus the lender’s charge for making the loan, called the margin. Common indexes are the Constant-Maturity Treasury (CMT) Index, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). Lenders will use your credit record as the basis for determining their margin.
Your payments will also be affected by any caps (or limits) on how high or low your rate can go. If the index rate that controls your mortgage goes up, so does your interest rate (and payment). If it goes down, your monthly payment might go down. Although these caps can change, practically all ARMs (by law) must limit the rate of increase for the lifetime of the loan.
What do you need to know before you purchase an ARM?
In order to make an informed decision regarding whether to choose an ARM, you should answer these questions:
- Is your income likely to increase enough to cover the higher payments if interest rates go up?
- What other debts are you likely to assume during the life of the loan that will affect your ability to pay more for my house?
- Will you stay in the home long enough for the adjustable rates to affect me? (There is an increased likelihood that an ARM will cost you more over the long term than a fixed-rate mortgage.)
- Do you intend to pay the loan off early?
Because there are different types of ARMs, from Interest-only ARMS to Payment-option ARMs to Hybrid ARMs – you should compare the various features to see which one will work best for you. There are also convertible ARMs available that will let you convert your ARM to a fixed-rate mortgage.
Where can you find an ARM?
Mortgage loans – including ARMs – are available through a variety of lenders, including banks, mortgage companies, and credit unions. You can also get a loan through a mortgage broker – someone who will find a lender for you for a fee; be aware, however, that unless you have a written contract with a broker, he or she is not required to find the best deal for you.
The bottom line is, like everything in life, the type of mortgage you choose is a calculated risk. You get a lower initial interest rate with an ARM, but you assume more risk over the long haul than if you had decided on a fixed-rate mortgage.